Bookshelf Update: Diary of a Hedge Fund Manager

Although [self-professed to be] poorly-written and self-promoting, the book communicated an important point about the hedge fund industry gone awry.

Hedge funds were conceived to deliver hedged, downside protection and superior risk-adjusted returns, but now so many funds are marketing schemes to generate fee income for general partners.

I’m adding Diary of a Hedge Fund Manager by Keith McCullough & Richard Blake to my Bookshelf. Along with a stack of other books, reports & research, this read accompanied me on a recent flight to Milan, Italy. My uncensored opinion of the book itself: it’s perhaps the most unintentional piece of self-aggrandized marketing I’ve ever read. Reminds me a bit of Jim Cramer’s Confessions of a Street Addict (also in my Bookshelf). The author, Keith McCullough, has an initiative–truthfully an agenda of honesty. He wants to lift the curtain on the hedge fund industry like Toto on The Great Wizard of Oz, but his anecdotes accumulate to underlying resentment per the influence of his own experience. There’s a baked-in bias that can’t be discounted no matter how accurate Mr. McCullough’s account.

Further, in sticking with the comparison to Mr. Cramer’s work (a TheStreet.com plug), I regard Mr. McCullough’s Diary more as a long-form pamphlet for his HedgeEye website service. I wanted a heavily anecdotal diary, parenthetical opinions if absolutely necessary. Instead, the opinion warrants the story, not the inverse. Since that was my own desire (not the author’s), maybe I’ll draft an anecdotal text about my own experiences in finance one day. (The author self-professes two facts: first, he’s not a good writer; second, he undertook this book along with a blog after he was laid-off. In vindication after his lay-off, Mr. McCullough admittedly started both the book and the blog as time capsules for his son to read in the future.)

This semi-memoir warrants Bookshelf status because I extracted some interesting wisdom, despite my criticism. I love Mr. McCullough’s take on the hedge fund industry gone awry:

Hedge funds weren’t going to be sustainable, because they weren’t being run as businesses… Hedge funds were being run more as vehicles for producing fee revenue for the hedge fund management company, but with less than the average adequate downside protection that the hedge was supposed to provide. Hedge funds had originally been conceived as sophisticated vehicles for delivering Wall Street’s finest investment acumen, with built-in downside protection, i.e., the hedge. Now, they had developed into nothing more than highly touted engines for producing excessive compensation… In a different generation, there had been a handful of talented PMs, Soros and Robertson and Steinhardt and Cooperman… somewhere between “1 & 20” and “2 and 20” and fund of funds and rich lists, the industry went off the grid in terms of basic principles.

He’s a purist, and I love it. In my humble opinion, it’s not so much that new management styles have arisen (long/short, market neutral, arbitrage, leveraged, distressed debt, etc.) to saturate the hedge fund niche, but rather, I’m disturbed by how many of these non-core strategies misrepresent themselves to investors. Because the hedge fund “asset class” imparts an inference of downside protection and outsized risk-return, your leveraged-long funds (for example) get to piggyback on that notion, dismissing the potential for substantial loss but for a compulsory disclosure: “past returns are not indicative of future results” or “investments bear risk, including the loss of capital.”

I’m inclined not to feel too bad for individual investors that turn their palms to the sky when they lose 50% in a quarter in a momentum fund. A hypothetical investor’s reaction, ‘XYZ Fund made it sound like I couldn’t lose!?’

And my hypothetical response, ‘Their offering documents disclose the risk of loss, but you got sucked in by a marketing scheme, window-dressing, lipstick on the pig.’ Nothing is a guarantee. There is no risk-free asset–whether US Treasuries, housing, long-short, algorithm, LTCM or Paul Tudor Jones. A simple fact of life.

Of course I can understand how the individual investor gets sucked in by the hype. Financial consumer protection bureau? Sure, maybe that helps, but often the longer the disclosures section, the more consumers glaze over. It’s an ugly underbelly of capitalism, and defrauding consumers is as old as mankind itself. (That still doesn’t justify anything.) Similarly, institutional investors (i.e. pensions and endowments) often have little alternative but hedge funds, who can swallow billion dollar gobs of capital whole. A Fund of Funds can not only swallow that kind of capital, but it also claims to conduct rigorous due-diligence on the underlying hedge funds. The marginally more holistic service provided by Fund of Funds is a significant convenience to their institutional clients, who are saved the mundane task of due-diligence. Problem is, most Funds of Funds feign that due-diligence and just read the prospectus, which misrepresents the risk.

The industry needs a re-educated consumer and terse/blunt prospectuses. While it’s attributable to their own lack of commonsense, consumers should understand that there is no guarantee in investing, no manager nor algorithm knows the future for certain, and there really is a risk/reward tradeoff that’s subject to gravity. That’s cliche, but it’s also buried under the facades erected by most funds.

Finally, I hate style-boxes, but certain [all] classifications of hedge funds should have to concisely disclaim themselves in a uniform fashion. Regulators need to stop the marketing-skew in hedge fund offering presentations, because no matter how brilliant the tactical opportunity or the quantitative algorithm, there’s exponentially greater risk in this new class of fringe funds than in a core strategy of the garden variety. If run correctly, your purist’s fund with hedged allocations (and a downside-protection/risk-adjusted return mandate) really shouldn’t get wiped-out. Your leveraged fund will always run the risk of implosion. So, the portfolio manager can tell me his strategy and try to sell me on why he’s better than the rest. That’s his subjective & objective pitch, but right up there with that marketing has to appear the concise warning:

[Despite our trackrecord] or [Despite the historical accuracy of our models] or [Despite our conviction in a favorable outcome]

AND

[I really don’t know what the future holds] or [There is no magic bullet in investing] or [I put my pants on the same way everyone else does in the morning]